Question

Why compare common sized income statements for these firms and what DuPont ratio does this comparison provide answers for?

Answer 1

Common size Income Statement

Common size income statement is a statement in which each item of the income statement is expressed as a percentage of revenue.

It facilitates easy comparison. It helps in the analysis and comparison of firms of different sizes. It helps in understanding the financial position of the firm. It helps in comparing the financial performance of a company with the previous period.

DuPont Analysis

DuPont analysis is a financial ratio based on return on equity. It analyzes a company’s ability to increase its return on equity. It breaks down the return on equity to three ratios:

1.Profit Margin

profit margin measures how well a company manages its sales compared to itz expenses.

2.Total asset turnover

Total asset turnover measures the company’s ability to generate sales from its assets.

3.Financial Leverage

Financial leverage measures how much of the company’s assets are financed with the shareholder’s equity.

A company concludes that it can increase its return on equity by maintaining a high profit margin, increasing asset turnover and leveraging assets. If a company’s ROE is high, it must be because the company’s profit margin is high or has high asset turnover or it has high leverage.

Formula for computing DuPont ratio using the 3-sector model:

DuPont ratio=Profit margin*Total assets turnover*Financial leverage

DuPont ratio= Net income/Net sales*Net sales/Average total assets*Total Assets/total equity

A company’s ROE throws light on where its strength lies and if there is room for more improvement. It can be further decomposed to five ratios using the 5-sector model.

ROE= Tax burden*Interest burden*EBIT margin*asset turnover*financial turnover.

ROE= Net income/EBT*EBT/EBIT*EBIT/revenue*Revenue/Average assets*Average assets/Average equity.

Dumont analysis helps to compare similar companies with similar ratios. It helps investors assess the risk in each company. It helps to determine the reason for the high or low ROE. It helps to understand the strengths and weaknesses in the company.

I hope that was helpful :)